Why Inflation Can Lead or Lag Economic Cycles

Yesterday, we reviewed the PPI data. Today at 8:30, we get the Consumer Price Index (CPI).

There is a certain faction of folks who missed the early warning signs of inflation. These same folks are now telling us not to worry about inflation, since the threat of an economic slow down is more important. Yes, the same folks who told us there wouldn’t be a recession, and are now saying its over, have brought the same wonderful approach to rising prices. They are not to be trusted.

Here’s the way their arguments have run:

PPI is too hot?
Not to worry, its CPI that matters.

What? CPI is too strong?
Well, Ignore Food & Energy, and focus on Core inflation.

Huh? The Core is elevated?
Ya know, it doesn’t really matter, because Inflation is a lagging indicator.

How’s that for an utterly intellectually dishonest approach? And factually wrong to boot.

Mich_max_630_378 Let’s start with Federal Reserve: They look to future inflation expectations via University of Michigan (chart at right) as their leading inflation indicator. This is why there is an ongoing attempt by some to convince the public that — beyond what their own lying eyes are telling them about price increases — there is no inflation. 

Beyond the usual inflation denialists, however, this morning I want to discuss why inflation isn’t properly described as a lagging indicator, and shouldn’t be dismissed as just so much history. Those who do so do at the risk of their own financial peril.

First off, the technical definition: Only the services portion of CPI goes into the Conference Board’s lagging indicators. Hence, everything from crude to food to manufactured goods is not technically part of the lagging indicators basket.   

However, that fails to capture the gestalt of what it means to be a lagging economic indicator. A quick review: A lagging indicator changes its direction after the business cycle changes. Lagging does not mean it is reported after the fact (all indicators are reported that way). Rather, what it lags is the cycle, and not real time.

For example, Unemployment tends to tick up for months after a recovery has began. Hence, it is said to lag the cycle. Temp help, on the other hand, leads the cycle, but is not one of the 10 Conference Board LEIs (but average manufacturing-worker workweek is). The Stock market tends to lead the cycle turns,  falling before a recession starts, and rising before the recovery is apparent (there are many exceptions to this). Thats why its part of the LEIs.

Hence, PPI, reported yesterday, is not a lagging indicator. And properly understood, it provides lots of insight into future inflation.

How? We can track inflation as it moves through the manufacturing pipeline, from "crude" (raw materials) goods to "finished goods." What has been taking place over the past few years has been the price of "crude goods" have been escalating a whole lot faster than the finished products. This is evidence of future inflation, as it eventually shows up in the form of higher prices for finished products.

For a long while, manufacturers and retailers were eating these price pressures, making up for them via a combination of increased efficiency,  outsourcing to the lowest price producer overseas, and absorbing a hit to their margins.

But that can only go on for so long, and it seems to have reached a peak several quarters ago.

How do we know this? The "inflation spread" between the crude goods and finished goods. Its now at record levels. This spread is even greater than it was in the late 1970s/early ’80s.

Producer Price Inflation Spread


Chart courtesy of Bill King, Bloomberg


This is why I took no quarter yesterday from the usual claim that inflation is a lagging indicator. Its not;  a portion of the CPI however, is.

I hope this clarifies your understanding of inflation.


UPDATE: April 16, 2008 3:15pm

A friend sends along the following comments:

"Inflation is a lagging indicator which peaks long after an expansion in economic activity has ended. The expectation is that a moderation in inflation will emerge as the economy slows in the next few months."

For the most part, that’s true.

Except when its not.

Like in the 1970s. Or, over the past few months. Recall Q1 2008 saw GDP at 0.6%, and inflation accelerated. So either inflation is greatly lagging — or perhaps, in the current instance its not quite the lagging indicator everyone thinks . . .



University of Michigan Inflation Expectation   

Global Business Cycle Indicators   
The Conference Board, March 20, 2008

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What's been said:

Discussions found on the web:
  1. austincompany commented on Apr 16

    On a personal note, our company (printing) has been hit with three price increases just last week. A 6% increase in our UPS rates, a 9% increase in our packing material and 3% on paper and chemicals.

    And yes, we have eaten these increases before – but not anymore. We are increasing our retail prices 5% on May 1st. So, the idea that companies like mine have been a temporary “plug” in the dike are true, but not anymore…

  2. Greg commented on Apr 16

    If you anyone is interested in the differences between US and EU growth, I recommend:

    “On the spurious differences in growth performance and the misuse of National Accounts data for governance purposes”

    by Jochen Hartwig

    Review of International Political Economy, 13:4, October 2006, pg 535-558

  3. Michael Donnelly commented on Apr 16

    So PPI ex: the lagging part is not lagging?

    That by definition is true, still total PPI, and Total CPI have long been classified as lagging indicators.

    However it’s mostly all a moot point by now, we are about 6 months into this recession and inflation has not eased off even a little, that is a big problem. And Crude PPI is a leading indicator and it’s up 30% y/y

  4. Emmett commented on Apr 16

    Mine is an engineering firm that builds serial and custom manufacturing equipment for the semiconductor industry. This is high value add manufacturing. We’re a global operation, and our U.S. plant is one of many world wide.

    We’ve enjoyed the advantage of lower labor rates (compared to EU), but our materials costs are inflating, owing to the weak dollar and the fact that metals, ceramics, glass, etc. is sourced globally. Stainless Steel, for instance, has seen a 30% increase in raw material costs in the last 12 mos.

    We’re more able to pass this on to our offshore customers because our corresponding lower labor component still puts us at a pricing advantage. (Our competition is Europe based.)

    We’re a cap equip supplier, meaning our order fulfillment cycle can be as long a 12 months. COGs inflation poses itself as pricing risk for us. 12 month cycle time means we buy about 3 months after receipt of order (design is first step).

    I get killed by my management because I struggle to predict costs and my burned fingers have me now projecting lower margins in anticipation of higher materials costs.

    Gotta think different now. That is one of the hidden costs of inflation… lack of visibility into production costs for manufacturing.

  5. dblwyo commented on Apr 16

    The jumps in CPI are, IMHO, being driven by suppliers thruout the entire chain being forced to pass on rapidly rising costs. The consequences of this are potentially severe and are a real candidate for Black Swan status. In the short-run the pressure on margins will be tremendous. In the longer-run natural adjustment processes in China, et.al. are jump-shifting to the export of inflation instead of deflation as we all got used to. Most critically this particular Swan is threatening severe political stability problems thruout the developing world.
    Ahem – this is a problem I’ve been charting for some time now and one pass is here:
    My basket of high-frequency indicators indicates that the real money supply continues to contract, despite inflation, because of continuing credit problems:

  6. NOR commented on Apr 16


    As an overseas viewer I need to bring forth the question if it does matter what the CPI is anyway?

    It is a fraud number anyhow, is it not?

  7. VennData commented on Apr 16

    My morning bagel went from fifty cents to sixty cents last week. It’s not twenty percent inflation: First off, it happened last week, hence, it’s a lagging indicator. Second: They’re not going to raise my bagel another dime next week. Third, it’s only a dime.

    Ta’dahhh… See? there is no inflation.

  8. dblwyo commented on Apr 16

    Emmett and others with similar cases – thanks for sharing that story. A real-world, down-in-the-mud example of the broader phenomenon. You can dload the data used on a broad scale for your particular industry and goods and see the particulars. You also ought to be taking a parallel look at the demand side, which you can do at the overall level or downto the industry level, again with dloadable data. The HF indicators might be a start. Most of my data comes from the St.Louis Fed FREDII system but you can get the detail from the BLS, et.al. I’d suggest anticipating a slowdown in demand as the non-decoupled lags catch up with the Europeans and other customers as well as rising input costs. FWIW.

  9. stuart commented on Apr 16

    You can’t trust anybody..this is total BS. Banks now deliberately under reporting LIBOR.. Confidence has been one of the main casualties in the last 12 months. Where’s the accountability, consequence for deceit and fraud…pathetic.


  10. wally commented on Apr 16

    “I took no quarter yesterday from the usual claim that inflation is a lagging indicator”

    Besides, it would only have been worth 20 cents.

  11. grumpyoldvet commented on Apr 16

    CNBC is once again spinning the CPI increase as “not bad at all”…after listening to Joe Kiernan say he listens to Rush Limbaugh for political analysis, I now understand their collective disconnect from reality….when is the sircus coming to town….never left…it’s at CNBC,,,liberal media my ass

  12. K3 commented on Apr 16

    Were it not for the ~50% run-up in oil prices from 2007 to 2008, we would not be talking about recession in 2008 – or nearly as much inflation: The discussion would be about the continued slow economic growth from the modest drag caused by housing.

    Productivity data from recent quarters suggests that manufacturers will be able to continue eating some of the higher pipeline costs brought about by higher commodity prices.

  13. Simon commented on Apr 16

    Well that CPI just came out and I just got told by one of our analysts that next months gas component could be negative due to seasonal factors. (WTF!!!) Are any of these figures a true and accurate picture of inflation? I am beginning to wonder if these numbers are calculated by Fitch, Moodys or S&P

  14. stuart commented on Apr 16

    RE: CPI report.

    Gasoline up only 1.3% . Phew, that’s a relief. What I see at the gas pumps I guess must be a mirage. CPI report is more BS, more lies.

  15. mikkel commented on Apr 16

    I don’t know Barry, I still think you are conflating a couple of factors. Really it’s all about margins and pricing power as the first few comments on this thread talked about.

    Crude PPI (and then PPI in general) is obviously going to pressure margins, but if they can pass it on then there will be a big increase in CPI while the margins stay OK. Once the consumer can’t afford to continue shouldering the burden, then they are going to have to cut costs, which will hurt margins. Of course they can only cut so much, so eventually price increases will have to be passed on regardless of the decrease in sales. But the decrease in sales will cause lower demand for crude materials…etc.

    This is why inflation targeting doesn’t make sense, as the interplay between parts of the system will dramatically affect it and can have bifurcation points where a lot of built up inflation/deflation will explode regardless of monetary decisions.

    The current situation is completely bad. The core/finished PPI spread shows that companies are taking huge hits on their margins just to get it out the door, and the huge CPI vs core spread shows that the necessities are skyrocketing while companies are having a hard time getting pricing power in discretionary goods. The inflation in things we need and deflation in things we want is something that Minyanville has been talking about for a year and people are being completely boneheaded in their focus.

  16. Ross commented on Apr 16

    Raw materials…..event driven. Oil up? Monitize.

    Oil up. Pass through the system with a lag. Monitize.

    System prices up. Pass through the system. Monitize.

    Service prices lagged up. Wage pressures. Monitize.

    The base commanality through each stage is Monitize.

    Geez. Every cycle every 25 or 30 years needs to be relearned. Put it in a book.

    “In Case Of Inflation, Read THIS!”

  17. Vermont Trader commented on Apr 16

    BR – Thanks, I couldn’t stay away anyhow.

    When you step back what really matters is our standard of living. Inflation just measures the cost of that lifestyle and its atainability.

    Americans have a very high standard of living compared to most of the people in the world. We take a disproportionate amount of the “pie” yet we no longer provide a disproportionate amount of production.

    I would argue that the U.S. (and European) standard of living will decline vs. the developing world over the next 20 years. The pie is going to be divided up differently and we will get a smaller slice in the end (even if the whole pie gets bigger).

    Inflation (including dollar devaluaion) will be the means to that end. As the things we need to maintain our standard of living become more expensive we will have to lower our lifestyle.

    That is where we are headed in the end.

  18. DonKei commented on Apr 16

    Vermont Trader,

    “Inflation (including dollar devaluation) will be the means to that end.”


  19. bdg123 commented on Apr 16

    Inflation is a lagging indicator. It can never be a leading indicator. It is a measure of what happened yesterday. Inflation is caused by money but not only money. One can argue all day long but there are other variables in the inflation equation. And, that is easily proven. People read a Rothbard book and think they have the world by the tail but he was wrong as often as he was right. Because his view of the world was incomplete. Of course, people on all sides of this argument cite what supports their positions. A trend follower might view inflation’s historical movement as a prediction of future trend and they will be right until they are wrong. Just like those who predicted the housing market would go to the moon were right. For a while. And, those predicting China’s economy will grow to infinite based on lagging or historical data.

    Inflation isn’t always correlated to movement of the dollar. Dollar prognosticators are conveniently right for the wrong reasons. Dollar goes down and things cost more is true with many caveats. Dollar goes up and things cost more also is true with many caveats.

    One must understand the fundamentals to understand what is going on at any particular point in time. Technical or quantitative analysis is a self fulfilling prophecy of fundamentals. Be that of an economist or stock market technician. That is why quantitative/technical analysis goes in and out of vogue. It was hot in the 1970s and became generally worthless throughout the last 1980s and 1990s. Then came into vogue again in the last decade. When the fundamentals change technicals change. That leaves data whores typically wrong on most and often all accounts. Which is why economists are almost always wrong at major turning points.

    The U.S. does not have inflation. It is deflating. People say we are importing inflation. That is completely erroneous. We are exporting our deflation. And, that is why commodities are rising and wages are falling. Soon, likely 2009 but possibly in the second half of 2008, the rest of the world will plunge into a deflationary funk and demand for commodities will abate. Likely drastically. There are only a few outcomes that could save commodities from a massive plunge. One might be that the deflationary funk causes such social turbulence in commodity producing emerging markets as to make them scare. The others……..well………We shall see.

  20. crack commented on Apr 16

    This round of inflation has been different. There has been no wage inflation. All of the increased prices have come from demand for raw materials. This is cost-push inflation without a supply shock.

  21. DL commented on Apr 16

    As stated above:

    “The ‘inflation spread’ between the crude goods and finished goods. It’s now at record levels. This spread is even greater than it was in the late 1970s/early ’80s”.

    This statement would appear to make the case for core CPI being a lagging indicator, at least in this economic cycle.

    Gold and silver should continue to rise for the foreseeable future.

  22. Barry commented on Apr 16

    Actually, it makes the case that Producer Inflation in the present case neither leads nor lags the cycle.

    Remember, lagging indicators turn after the economy turns…

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